David GrabinerBogleheads 2016

September 29, 2016

Taxes and Investing

First things first

● Do not treat this as tax advice– Not just a legal disclaimer; only your tax

advisor knows the details of your tax situation

● Only consider taxes after you have chosen your asset allocation (to determine risk)

● Remember that your goal is to optimize after-tax returns, not minimize taxes

– Taxes are a cost, and must be weighed against other costs or benefits

How to do tax-aware investing

● Understand taxes● Then go through the usual stages of

investing:– Choose accounts

– Choose investments for each account

– Manage your accounts

– Withdraw from the accounts

Tax-aware investing questions

● First question: How are investments taxed?● Which accounts should I invest in?● What should I hold in which account?● How should I manage my taxable account?● Which account should I withdraw from?

How are investments taxed?

● Marginal tax rate– How it is determined

– How to use it for tax decisions

● Types of tax-favored accounts● Taxation of taxable accounts● State income taxes

Marginal tax rate: tax on the dollars in each bracket

0 100000 2000000

10000

20000

30000

40000

50000

2016 tax for a married couple

Taxable income (all ordinary income)

Tax

Marginal tax rate: rates on different types of income

A married couple with $100,000 salary, $10,000 qualified dividends, and $30,000 in deductions and exemptions

$4700 qualified dividends in 25% bracket Taxed at 15%

$5300 qualified dividends in 15% bracket Not taxed

$51,450 regular income in 15% bracket Taxed at 15%

$18,550 regular income in 10% bracket Taxed at 10%

$30,000 deductions and exemptionsNot counted in bracketing

Marginal tax rates: computing the marginal rate

The couple earns another $1000 in ordinary income. Their tax rises by $300, so their marginal rate is 30%.

$5700 qualified dividends in 25% bracket $1000 more at 15%

$4300 qualified dividends in 15% bracket Not taxed

$52,450 regular income in 15% bracket $1000 more at 15%

$18,550 regular income in 10% bracket Taxed at 10%

$30,000 deductions and exemptionsNot counted in bracketing

Marginal tax rate: phase-ins/outs affect the rate

● Child tax credit: extra 5% in phase-out● Education credits also phase out● ACA surtax: at high incomes, extra 0.9%

on salary, 3.8% on investments● Taxation of Social Security benefits

– In most of the phase-in, 27.75% marginal rate in 15% bracket

– A few taxpayers have 46.25% marginal rate in 25% bracket

Marginal tax rate: Alternative Minimum Tax

● Compute tax under regular and AMT rules, and pay the higher tax

● Marginal tax rate is 28%; regular rate of 15%/20% on qualified dividends, LT gains

● Large phase-out of personal exemptions; marginal rates are 35% and 22% then

● State tax is not deductible; add full state tax rate to your marginal rate

● Some munis are taxable under AMT

Marginal tax rate: why it is important

● The effect of a tax decision is based on your marginal rate

– Example: If you contribute another $1000 to your 401(k), you save tax at your marginal rate

– When you withdraw this $1000 plus gains, it is taxed at your marginal rate in retirement

Marginal tax rate: using it for comparison

● Say your marginal rate now is 25%, and your 401(k) will double in value

– You could contribute $1000 to a traditional 401(k), which would grow to $2000, and pay tax when you withdraw it

– You could contribute $750 to a Roth 401(k), which would give you $1500 in retirement

● Break-even if you retire at a 25% marginal rate● Traditional is better if you retire at a lower

marginal rate

Marginal tax rate:rates used for examples

● For most examples, we will use marginal rates for a middle-income investor in a state with no income tax

– Regular income taxed at 25%

– Qualified dividends and long-term gains taxed at 15%

● If you pay state tax and itemize deductions, add only 75% of the state tax rate

How are investments taxed?

● Marginal tax rate● Types of tax-favored accounts● Taxation of taxable accounts● State income taxes

Types of tax-favored accounts

● Tax-deferred: Traditional IRA/401(k)/etc.– Contributions usually deductible

– Withdrawals taxed (except non-deductible contributions)

● Tax-free: Roth IRA/401(k)/etc, HSA, 529– Contributions taxed (except for HSA), can be

withdrawn tax-free

– Withdrawals tax-free if you follow the rules

How are investments taxed?

● Marginal tax rate● Types of tax-favored accounts● Taxation of taxable accounts● State income taxes

Taxation of taxable accounts: dividends and interest

● Bond interest (reported as dividend) taxed at full rate

– Municipal bonds are exempt from federal tax; most states tax bonds from other states

– Treasury bonds are exempt from state tax

● Stock dividends taxed at a lower rate if qualified according to IRS rules

– REIT dividends are usually not qualified

– Most dividends from stock funds qualified, with US often 100%, foreign 70%

Taxation of taxable accounts: capital gains and losses

● When you sell an asset, you have a capital gain or loss equal to the change in price

– Losses offset gains, and up to $3000 per year of losses offset ordinary income

– Long-term gains (more than 1 year) taxed at the same rate as qualified dividends

– No capital-gains tax if you never sell (leave to heirs or donate to charity)

● If a mutual fund sells an asset for a gain, and has no offsetting loss, you pay the tax

Taxation of taxable accounts: visible and hidden tax costs

● Distributions are taxed when paid● Stocks have an extra tax cost: capital gains

when sold (at lower long-term rate)● Municipal bonds have a hidden tax cost

– Difference between muni and taxable yields for bonds of the same risk is a cost paid to avoid tax

– Rule of thumb: 1/3 of muni yield (break-even in 25% bracket)

How are investments taxed?

● Marginal tax rate● Types of tax-favored accounts● Taxation of taxable accounts● State income taxes

State income taxes

● More information on the wiki: State income taxes

● Understand what is taxed (and the rate) by your current state/county/city, and by the state you intend to retire in

● If you itemize deductions, this reduces your effective state tax rate by the federal rate

● Caution: the lists of states on the next slides may not be complete

State income taxes:important issues (untaxed income)

● No income tax: AK, FL, NV, SD, TX, WA, WY

● Tax on dividends and interest only: NH, TN● Large exemption means many retirees pay

no tax: GA● Social Security not taxed: most states● Retirement income not taxed, or large

exemption: many states

State income taxes:important issues (deductions)

● No deduction for IRAs: MA, NJ (gains taxed); PA (gains not taxed after age 59-1/2)

● No deduction for employer plans: NJ (401(k)s are deductible, but not others; gains taxed); PA (gains not taxed for distributions in retirement)

● HSAs not recognized: AL, CA, NJ

● No or very limited itemized deductions: CT, IL, IN, MA, MI, NJ, OH, PA, RI, WV

● Federal tax deductible: AL, IA, LA, OK; limited in MO, MT, OR

Tax-aware investing questions

● First question: How are investments taxed?● Which accounts should I invest in?● What should I hold in which account?● How should I manage my taxable account?● Which account should I withdraw from?

Choosing accounts

● Get your employer match first● Max out HSA if eligible● Prefer any tax-favored account to taxable● Contribute to IRA (which usually must be

Roth) in preference to an inferior 401(k)● Traditional versus Roth is a more

complicated decision

Choosing accounts: ways to get more money in tax-favored

● Health Savings Account– You must have a qualifying high-deductible

health plan; compare total costs including tax savings

● Backdoor Roth IRA– If over the Roth IRA contribution limit,

contribute to non-deductible traditional IRA, then immediately convert to Roth

– Only works if you don't have another IRA (or convert other IRAs as well)

Choosing accounts: Traditional or Roth?

● More information on the wiki: Traditional versus Roth

● Several versions of the decision– Employer offers both Traditional and Roth

– You are eligible for deductible IRA/401(k) or Roth IRA (always use Roth if traditional is non-deductible)

– You can convert a traditional IRA to a Roth

Choosing accounts: Traditional or Roth?

● Non-tax considerations– Get the full employer match first

– If you can't contribute enough to a Roth 401(k) to get the full employer match, you can contribute more to the Traditional 401(k) and get a larger match

– If you have a bad 401(k), prefer an IRA to unmatched 401(k) contributions

Choosing accounts: Traditional or Roth?

● Prefer a Roth if you are likely to retire at an equal or higher marginal tax rate:

– You are in the 15% bracket

– You are starting out in a low tax bracket, and expect to be in a higher bracket for most of your career

● Prefer a Roth if you may retire at an equal or slightly lower rate (large Traditional account or pension) and can max Roth out

Tax-aware investing questions

● First question: How are investments taxed?● Which accounts should I invest in?● What should I hold in which account?● How should I manage my taxable account?● Which account should I withdraw from?

What goes in which account: general principles

● Choose the best options in your employer plan; this is more important than tax issues

● In your taxable account, use I-Bonds, low-yielding bonds (municipal bonds in a high tax bracket), and stock index funds and ETFs (either US or foreign)

● What goes in Traditional or Roth doesn't matter much; slight advantage for stocks in Roth

What goes in which account:more information on the wiki

● Tax-efficient fund placement: How to estimate tax costs of different investments

● Tax-managed fund comparison: Vanguard has funds which are explicitly tax-managed; do you need them? (Usually not)

● Tax-adjusted asset allocation: explains why stocks in Traditional or Roth doesn't matter much

What goes in which account: what is best in taxable accounts?

Stocks Bonds

Large-cap index funds or ETFs I-Bonds

Small-cap ETFs, or index funds with ETF class

Low-yielding bonds or cash (munis around 2%, taxable under 3%)

Value ETFs, or index funds with ETF class

TIPS, as long as inflation is low

Small-cap or value index funds without ETF class

Medium-yielding bonds (munis around 3%, taxable around 4%)

Low-turnover active funds Bonds if yields become higher

REITs

High-turnover active funds High-yield (junk) bonds

What goes in which account: estimated tax cost over 30 years

REIT index

5% bond

Low-turnover active

2.5% bond

Small-cap ETF

Large-cap index

0 5 10 15 20 25 30 35 40

If soldIf not sold

What goes in which account: get the most from your employer plan

● Use the best options in the employer plan before optimizing for taxes

● Many employer plans have better options in some asset classes

– TSP G fund: a bond fund with no risk

– TIAA Traditional Annuity: also better than any retail fixed-income option

– Many 401(k) plans have an S&P 500 index fund as the only low-cost option

What goes in which account: bonds or stocks in taxable?

● Tax cost of stocks depends on your bracket– 15% bracket: zero tax cost on stocks

– Most brackets: tax cost on stocks and hidden tax cost on munis are comparable if yields are close

– 39.6% bracket, or you are in a high-tax state and can use munis from your state: tax cost on stocks is higher if yields are close

● If you start with bonds in taxable, and yields rise, you can switch for little tax cost

What goes in which account: US or foreign in taxable?

● If yields are equal, tax cost on international funds is slightly lower; the foreign tax credit more than compensates for the non-qualified dividends

● International yields have been higher since 2008, making US slightly better

● Whichever way you started, not worth paying a tax cost to switch

What goes in which account: avoid balanced funds in taxable● You might want to sell bonds (to hold fewer

bonds, or a different type of bonds, or bonds in a different account)

– If you hold bond and stock funds, you can sell bonds for little or no tax cost

– If you hold a balanced fund, and you want to sell bonds, you must also sell stocks

● If you value simplicity, a target-date fund may keep an appropriate allocation for you

What goes in which account:what goes in traditional or Roth?● The IRS (and state if applicable) own part

of your traditional account; once you adjust, it doesn't matter

– $7500 in a Roth and $10,000 in a traditional account will have the same after-tax value if invested the same way

– $10,000 in a Roth has higher expected return if invested in stocks than $10,000 in traditional, but also higher risk, so it isn't really a gain

Tax-aware investing questions

● First question: How are investments taxed?● Which accounts should I invest in?● What should I hold in which account?● How should I manage my taxable account?● Which account should I withdraw from?

Managing taxable accounts

● Use specific identification of shares when selling to reduce taxes

● Use tax loss harvesting, selling shares at a loss (but stay invested in stock; you might buy a similar fund)

● Try to avoid selling for a gain to rebalance, but do sell if you must

● Donate appreciated shares to charity

Managing taxable accounts:specific identification of shares

● You bought 1000 shares for $20, 1000 shares for $40, and want to sell 1000 shares for $50

● IRS default: sell oldest shares, bought for $20, gives a $30,000 capital gain

● Average basis (allowed for mutual funds): average cost $30 gives a $20,000 capital gain

● If you identify that you sell the shares bought for $40, you have a $10,000 capital gain

Managing taxable accounts: how to do specific identification● You can usually identify when you sell● For non-covered shares (purchased before

2012), brokerage may not have records– For mutual funds, specify by mail or secure

E-mail: “Please sell 123.456 shares of the XYZ fund purchased on 7/1/07 for $20 per share, and buy the ABC fund”

– When you sell, cost basis on your Form 1099 may not be correct, but it isn't reported to the IRS; you can report the correct basis

Managing taxable accounts:tax loss harvesting

● In 2015, you bought $10,000 of a stock fund. In 2016, you sell it for $9000 and buy another fund. In 2030, you sell for $18,000 to spend the money.

– $1000 capital loss, $250 tax savings in 2016

– $9000 capital gain, $1350 tax bill in 2030

– Without harvesting: $8000 capital gain, $1200 tax bill in 2030

– You saved $100 in tax, and had 14 years to invest $250 before paying the $150 tax

Tax-aware investing questions

● First question: How are investments taxed?● Which accounts should I invest in?● What should I hold in which account?● How should I manage my taxable account?● Which account should I withdraw from?

Withdrawal: order of preference

● Take required distributions first● Taxable withdrawals with little or no gain● Taxable withdrawals for a gain when you

intend to sell eventually● Retirement plans, both Roth and traditional;

use traditional when tax rates are lower● Try to leave highly appreciated stock to

your heirs (or charity)

Withdrawal: withdrawing from taxable accounts

● Tax efficiency is still important– Prefer tax-efficient stock funds

– If possible, sell bonds and keep stocks in taxable

● If you withdraw $10,000, you can spend:– $7500 if the $10,000 is bond interest

– $8500 if it is a qualified dividend or long-term gain distribution

– $9250 if you sold a stock fund with a $5000 basis

– $10,000 if you sold a bond fund with no capital gain

Summary

● Understand your tax situation● Take advantage of tax-favored accounts● Put tax-efficient holdings in taxable

accounts● Minimize taxable gains, and harvest losses● When you withdraw, manage current taxes,

and preserve tax deferral

References

● Your tax advisor (who knows your own situation)

● IRS: https://www.irs.gov; state tax bureau● Much more information on the wiki:

Outline of tax considerations for investors● Tax software can be useful for

experimenting with potential tax situations; TurboTax has an online TaxCaster which can be used for testing